Legal News for UK Co-ops and Mutuals

This is a blog where brief information about developments in UK Co-op and mutual law will be reported. Readers of this blog will also find Linda Barlow's Co-operatives UK Blog at http://www.uk.coop/blogs/linda.barlow helpful. For an network of academics working on co-ops, mutuals and social enterprises visit http://blogs.kent.ac.uk/r-comuse/2012/09/welcome-to-r-comuse/

Thursday, November 28, 2013

Hedge Fund Cock Up?

This morning's Times carried this enigmatic piece on page 56:

"Co-operative Bank: Hedge funds planning to take control of the lender have been left with a potentially expensive loophole. At issue is £125 million of new capital that lower tier bondholders, led by the funds Aurelius Capital and Silver Point plan to inject."

"A group representing the hedge funds and other lower tier two investors on Thursday pledged its support for the restructuring, after asking the Co-op to make a last-minute amendment to the terms.

The change is intended to close a loophole that was providing an opportunity for brokers and traders to undermine the new equity issuance by submitting claims for larger numbers of shares than they were entitled to. This could have meant that the LT2 group ended up with a smaller equity stake than they expected.

“The LT2 Group confirms its support for the recapitalisation of the Co-op Bank and . . . is fully supportive of the new management team for the bank,” it said"

The detail of the new announcement on the Co-op Group website reveals that the Bank may apply to court to modify the Scheme of Arrangement. Some of the holders of LT2 bonds have requested that and the Bank is considering whether or not to make the application. The statement says that no slippage in the timing of the deal beyond 31.12.13. would be permitted. That is a PRA deadline on the capital. The legal obligation of some of the holders of these securities to support the Scheme (the "lock in agreement") would stay in place whether the Scheme is modified or not.

Here's the change the announcement outlines. Under the existing Scheme as proposed these holders get:

"a combination of:

£100 million of 11 per cent. Subordinated Notes due 2023 to be issued by the Bank (“Bank T2 Notes”); and

112,500,000 new ordinary shares in the Bank (“New Ordinary Shares”) representing 45 per cent. of the total issued share capital of the Bank following completion of the LME.

The holders of the Dated Notes will also be entitled to subscribe for 62,500,000 additional new ordinary shares in the Bank (the “Additional New Ordinary Shares”) at a price of £2.00 per new ordinary share representing 25 per cent. of the total issued share capital of the Bank following completion of the LME, for an aggregate consideration equal to £125 million, pursuant to, and on the terms of, the Scheme with such subscription being underwritten by certain persons who were holders of Dated Notes as at 4 November 2013. The Scheme provides that any holder of Dated Notes is entitled to elect to subscribe for between a minimum election of 50,000 (for an aggregate subscription price of £100,000) and a maximum election of 62,500,000 Additional New Ordinary Shares."

If the Co-op Bank made an application to court and the court agreed the modification they would get:

"a combination of:

£100 million of Bank T2 Notes; and

141,666,666 new ordinary shares in the Bank representing 56.67 per cent. of the total issued share capital of the Bank following completion of the LME.

The holders of the Dated Notes would also be entitled to subscribe for 33,333,334 additional new ordinary shares in the Bank at a price of £3.75 per new ordinary share representing 13.33 per cent. of the total issued share capital of the Bank following completion of the LME, for an aggregate consideration of £125 million3(iii), pursuant to, and on the terms of, the Modified Scheme. This subscription would be fully underwritten by, amongst others, the Ad Hoc Group. The Modified Scheme would provide that any holder of Dated Notes would be entitled to elect to subscribe for between a minimum election of 26,667 (for an aggregate subscription price of £100,001.25) and a maximum election of 33,333,334 additional new ordinary shares. The allocation mechanism for the allocation of additional new ordinary shares described in the explanatory statement dated 18 November 2013 relating to the Scheme would otherwise remain unchanged."Note 3(iii) reads: '33,333,334 (representing the balance of 13.33 per cent. of the total) will be available for subscription by holders of Dated Notes pursuant to, and on the terms of, the Modified Scheme for an aggregate consideration equal to £125,000,002.50 (representing an effective subscription price of £3.75 per share)'."

This appears to mean that they would get more shares up front and subscribe for fewer further down the line. However,:

"The total number of new ordinary shares in the Bank issued to holders of Dated Notes as a class under the Modified Scheme would be the same as the number to be issued under the Scheme."

I fear I am at the limits of my ability to interpret this information here but maybe a failure to get the Scheme modified could cost them £125m without changing the overall percentage holding they would have?

Maybe this was an error in transcribing what was agreed to the detail of the official Scheme documents or maybe it was only realised later that there was an issue about the timing and minimum and maximum permitted subscriptions by this Group and its effect on their stake?

The position of the classes of creditors and preference shareholders deciding by tomorrow whether to take extra money for early agreement will be unaffected by the proposed change so maybe a court would grant a modification if it was asked to?

Aurelius Sale?

The FT reported at 4.47pm today that Aurelius has "walked away" by selling most of its stake to another Hedge Fund.

"Aurelius piled into Co-op Bank’s lower tier two bonds as a severe capital shortage emerged at the lender in the summer. Along with several other hedge funds, including Silverpoint Capital and Beach Point Capital, it built up a blocking stake in the bonds, which it used to secure a far better deal for creditors than had originally been offered by the bank.People familiar with Aurelius’s decision to sell said it was based purely on economic value, as its bonds performed strongly after the restructuring deal was announced."

However, because key parts of the deal have already been contractually agreed, the obligation to vote for the Scheme and the commitment to the ethical aspects of the Bank's constitution will still bind the new owner of the Aurelius stake.

Flowers and the Chancellor

"On 22 November 2013 the Chancellor of the Exchequer ordered an independent investigation into events at the Bank and the circumstances surrounding them to take place under section 77 of the Financial Services Act 2012. Separately, the Financial Conduct Authority and the Prudential Regulation Authority each announced on 22 November 2013 that they are considering whether they should also launch their own formal enforcement investigations. The precise scope and timing of these investigations is yet to be determined.

The regulatory and other investigations that have been recently announced are likely to subject the Bank to greater scrutiny from regulators, will take management time and result in the Bank incurring costs not currently included in its business plan which cannot be quantified at this time. Recent events may have caused some brand and reputational damage, but it is too early to form a definitive view as to the extent of such damage. These recent events, together with the competitive landscape in which the Bank operates, the introduction of seven day account switching and the associated increased competitor marketing activity at a time when the Bank has been constrained in its ability to undertake its own marketing activity, may be a contributing factor to an increase the Bank has seen in the switching out of current accounts. However, the Bank's retail deposit base remains broadly stable and it is too early to identify any significant trends at this point. Further, the Bank's liquidity position remains stable. Overall, the Bank's performance has been consistent with or, in the case of costs, slightly better than, management’s expectations."

Wednesday, November 27, 2013

Co-op Bank Recapitalisation: Stage One and Its Timetable

Friday this week 29th November 2013 is the first key date in the long and complex process of saving the Bank from insolvency proceedings by recapitalising and demutualising it. The others are 11th December 2013 , the day of the Class Meetings to approve it and 16th December 2013, the date of the court hearing to finally approve it.

This post looks at that process, the legal mechanisms used to implement it and the timetable.

The Story So Far

In May this blog examined the Co-op Bank's credit rating downgrade. That was the first public sign of the trouble to come.

In June, I looked at Plan A for a rescue of the Bank in the light of the £1.5bn shortfall identified by the PRA.

In September, hints of the likely demutualisation and indications of the Hedge funds' demand for 100% ownership were addressed.

On 23rd October the scale of investor control was announced and later that month I shared my thoughts on the issue of the use of the name “co-operative” in that bank after it becomes 70% owned by stock market investors with follow up on Co-operatives UK's response.

The Plan in Summary: A Reminder

The Co-operative Group will give 70% of the equity shares in the Bank to the senior bondholder (i.e. those with the highest priority claim – upper tier 2) in exchange for about £940m of the debt they hold plus a £125m cash injection into the bank. The Group will continue to hold the remaining 30% in return for providing £462m in a new Group bond and cash.

The lower ranked bondholders who are mainly retail investors on a smaller scale but who would have lost their whole investment if existing priorities of debt had been followed, will be offered new bonds with a choice between continuing their existing annual payments for 12 years with no capital sum or a lower annual payment plus a future capital sum. (See the FT Outlineand Q & A)

The Legal Mechanisms Involved

Since this is a Law Blog, it might be useful to look at the legal basis and process for this crucial first stage of the recapitalisation plan for the Co-operative Bank PLC.

Why the Money is Needed:

Readers will remember that £1.5bn extra “common tier 1 Equity” is required by the bank as a result of the wide range of problems it has faced and the increased requirements imposed by the PRA and Bank of England for bank capital. The problems included the bad debt that Britannia brought, the bank's excessive cost to income ratio, the money written off on IT schemes, and the compensation it is having to pay as a result of mis-selling PPI to its customers.

“Para B.4b The capital shortfall is a result of continuing losses incurred by the Bank predominantly driven by impairment charges to the carrying value of the Bank’s loans, in particular corporate loans acquired as part of the merger with Britannia Building Society (Britannia) in 2009. Impairment charges for the six months ended 30 June 2013 were £496.0 million.

The Bank also has a high cost base relative to its revenue when compared with its peers. The Bank has an ageing IT platform that has suffered from under-investment in recent years and has failed to integrate Britannia into the Bank’s operations, resulting in significant cost duplications in front, middle and back office functions and a significant overlap in the branch network. In addition, the Bank’s revenues are impacted by it not having achieved sufficient penetration of its current account customer base and historically pricing certain of its products on terms more generous to customers than the market.”

- Page 8.

The recapitalisation plan will raise the £1.5bn in two ways:

A Liability Management Exercise in 2013 will contribute £1062m and

Another £333m - £170m by 30.06.2014 and another £163m by 31.12.2014 – will come from the Banking Group, the subsidiary of the Co-operative Group through which the Bank is held.

They are linked and conditional on each other but let's look at the Liability management Exercise today. The rest of the money only comes if that goes ahead and that question depends on alegal process. Let’s look at that.

The Liability Management Exercise: The Current Process

As the FT Outline and Q & A reported, the two main groups of securities (bonds or shares in the Bank) affected are:

5.555% perpetual subordinated bondholders - lower tier 2 (LT2) investors - hand over their £937m of debt plus £125m of new cash plus £38m of interest (£1100m in total) for 70% of the Bank’s ordinary shares. This Group includes the Hedge Funds and holders of 48% of these securities have signed up to a legal commitment to vote in favour of the Scheme in their meeting. So those votes are in the bag.

9.25% Preference Shares and 13% perpetual subordinated bonds - both mainly held by retail investors and lower in priority for payment than the other bonds. They would have been completely wiped out in the normal course of events but are offered £38m for their £60m. They can swap for either “Instalment Repayment Notes” which get 12 years of income with no capital at the end or “Final Repayment Notes” which give capital at the end of the 12 years but less income from interest in the meantime. If 75% of each of the two groups agree to swap by 29.11.13, they all get more than if that doesn’t happen. Their agreement to swap is taken as a vote for the Scheme. However, the whole scheme has to be agreed before anyone gets anything. If the financial incentive works, it will be known on 29.11.13 whether one or both of these groups have effectively voted in favour of the whole plan.

Legal Process and the Key Dates

This process involves a combination of legal agreement based on the common law of contract and procedures under the Companies Act 2006 to allow the imposition of what is agreed by a big enough majority on the minority.

Under the Law of Contract, agreement must be made with anyone who is to be legally bound by their promise. If people already have rights attached to their bonds or shares, Contract Law would require the agreement of each one of them before those rights were changed. Here the plan is to substantially change the rights of the holders of these securities. If each and every one of them had to agree, a tiny group could hold the rest to ransom and it would be impossibly complex to organise the arrangement.

To allow deals agreed through “creditor democracy”, Part 26 of the Companies Act 2006 provides a mechanism, now being used for the Bank Liability Management Exercise, to allow majorities to impose new terms on minorities. This requires court approval as well as special majorities in separate meetings of each sclass of creditors or members. Section 895 of the Act sets out the possible uses of the procedure for “a compromise or arrangement” between a company and its creditors or members or any class of them. In the case of the Co-op Bank, the Bondholders are creditors and the preference shareholders are members.

The first step is an application to the court to order class meetings of different groups of creditors and members. That was done for this Scheme on 18th November 2013 as planned and the Court ordered that the meetings be called on 11th December 2013 as had been intended all along. That meets the requirement of section 896 of the Companies Act 2006.

Under section 897 of the Companies Act 2006, a statement explaining the effect of the compromise or arrangement must be made available and with the creditors being involved about where it can be found. That has been done by the availability of the statement on the Co-op Group websitewhich is referred to in the Court Order.

The Scheme meeting will be held at 10.am on 11th December 2013 at the Bloomsbury Holiday Inn. Although it is referred to as one meeting, there are separate class meetings and the necessary majority has to vote in favour of the Scheme at each of those meetings. If any meeting does not get the necessary majority the whole Scheme collapses. According to the document on the Co-op Group website, the votes by Preference Shareholders will be at 1.00pm, those of 13% Bondholders will be at 2.00pm and those for the 5.555% Bonds at 3.00pm.

In each case the vote will be on an Extraordinary Resolution. A majority in number representing 75% in value of each class of creditors or and class of members voting either in person or by proxy at the meeting called under section 896 must agree the Scheme - s 899(1). That means that there must be a simple majority of votes by people present at the meeting and voting (in person or by proxy) and that simple majority of voters must also hold between them 75% in value of the holdings of all those present and voting (again in person or by proxy).

In addition each of the three classes must vote in favour of the Scheme by that dual majority and if they don’t the court has no power to sanction the Scheme and it cannot go ahead - 899(1) and Re Hellenic & General Trust Ltd [1976] 1 WLR 123.

If the meetings do pass the necessary resolutions by the necessary majority, the court may approve the Scheme so that it becomes binding on all those it affects whether or not they voted in favour of it s 899(1). As that wording suggests, the court has a discretion about whether or not to approve the Scheme. Even after approval by the correct majorities, it can refuse approval. However, the court will be unwilling to upset the Scheme on its own commercial assessment, especially if there is a large majority in favour of it in each class. That is because the test applied by the court is whether no honest and intelligent person among those affected by it could reasonably approve it and the more votes there are in favour the less likely that is - Re Equitable Life Assurance Society (No.2) [2002] EWHC 140 (Ch). It is also the case that the existence of an adverse situation facing the company if the Scheme fails is a factor in favour of approving the Scheme at least of all the procedural rules have been followed - Scottish Lion Insurance Co Ltd [2010] CSIH 6 at para 44 [LINK]. Given that the Scheme document indicates (at para 5) [link] that:

"If the Liability Management Exercise is not successfully implemented on or before 31 December 2013, the Bank therefore considers that the PRA would have a basis for determining that the Bank is failing, or is likely to fail, to satisfy its threshold conditions; that the power of the Resolution Authorities to exercise stabilisation powers under the Banking Act had arisen; and the Bank believes it is likely that the Bank would be subject to a resolution procedure under the Banking Act. The Bank therefore believes that there are only two realistic outcomes for the Bank, which are either its recapitalisation following successful implementation of the Liability Management Exercise or a failure of the Liability Management Exercise resulting in the Bank becoming subject to a resolution procedure under the Banking Act.”

The result of the votes at the class meetings will be announced on 12th December 2013.

The Court hearing to sanction the Scheme will be on 16th December 2013 and the result of the hearing will be announced “as soon as reasonably practicable” after the hearing.

Likely Outcome?

I don’t have a crystal ball. However, key factors making it likely that the necessary majorities will be found and that the court will approve the Scheme are:

The retail investors - Preference Shares and 13% Notes

They get quite a good deal they can get more if they agree the swap by 29.11.13 instead of waiting till 6th December and to get the extra they have commit to vote for the Scheme. They are treated generously. They can still get 12 years of income or less income plus some capital instead of losing the whole investment. Arguably, anyone investing in a security labeled as bearing a 13% return should have understood how risky it was and preference shares are shares and not debt. However, the potential PR disaster of a lot of elderly individuals with faith in the Co-op Bank ( or previously Britannia) having their savings wiped out, the great work of Mark Taber and others on their behalf, and the relatively small value of their total investments in the scheme of things has saved their bacon - as long as the Scheme goes through. They should be very grateful.

The LT2 Bond Holders - 5.555% Notes

This group get 70% of the Bank in return for all their bonds plus some cash. Whether that is a good deal depends on how the bank fares in the future. Negatives for the value of the Bank’s shares include the recent blizzard of bad publicity and political mud slinging around Paul Flowers and the plethora of enquiries into the Bank, the Group and the regulators. That all means that the controversy will run and run. However, if the business plan works and the Bank’s performance improves with its new capital structure, the new shareholders and the Co-op Group could do quite well. More immediately, holders of 48% of this class of securities are locked into voting in favour of the deal.

Both groups have been party to the detailed negotiations to agree the Scheme and seem to welcome it. If the Scheme fails and the Bank goes into “Resolution” (i.e. special regime for banks with financial difficulties) all parties will be worse off than they would be under the Scheme. The creditors and preference shareholders will either be wiped out or suffer significant loss.

For the Co-op Group, the “cross default” that Len Wardle was reportedas mentioning at the Co-op Group Half Yearly meeting might also arise. So there can be no doubt that agreement on this plan is also in the interests of the Co-operative Group and the whole co-operative movement.

We must hope that the Scheme is approved despite the demutualisation of the Bank that it will involve.